Why a Big Yahoo! Buyback Would Work

A Bloomberg article over the weekend suggests that Yahoo! (YHOO) is close to announcing a major stock buyback, using a majority of the proceeds from the recent sale of its stake in Alibaba Group.

Yahoo! will announce its earnings on Oct. 22, and CEO Marissa Mayer has indicated that she will be back from maternity leave by then -- she might even be back in the office today. That earnings call will be her first opportunity to speak directly to investors since she started. She has had lots of chats with employees but none yet directly with investors.

Some Yahoo! critics have complained that Mayer is wrong to use cash on stock buybacks. Some critics -- mostly venture capitalists whose portfolios hold "orphan" companies that they're looking to unload -- say that Mayer needs to reinvigorate Yahoo! by buying their companies.

When was the last time a spending spree in and of itself made a company relevant again?

Other critics have put forward the idea that doing anything along the lines of a special dividend or a stock buyback will do nothing in the long run to increase Yahoo!'s relevance, so why waste the money?

There are many examples of companies spending money on small buybacks or big dividends that do nothing to help the stock. However, Yahoo! is contemplating a big stock buyback, not another small one (over the past few years, it has brought the total shares outstanding down to 1.2 billion from 1.5 billion).

Let's say it takes $3 billion for buybacks. At today's $16 price, that's going to reduce about 16% of the shares outstanding and take the share count down to 1 billion.

The value of Yahoo!'s stake in Yahoo! Japan is currently $4.7 billion after tax. If it used $4 billion of that to retire shares at, say, $17 a share, that would take the share count down by another 235 million to, say, 765 million.

And then, if it took on some additional debt that's low cost and manageable -- $2 billion -- it could reduce another 111 million shares at $18 a share.

That would take us down to 654 million shares available in Yahoo!, compared with 1.2 billion today -- about half.

So what?, say Yahoo! critics.

But this isn't financial engineering.

Reducing your share count by half doubles the value of earnings for each share. That doesn't necessarily mean Yahoo! would suddenly become a $32-a-share stock, but it would certainly gravitate there over time, assuming it maintains its profitability.

It would also make Yahoo! a much cleaner pure-play company which might be more interesting for an acquisition.

Also, keep in mind that Yahoo!'s core business is trading at only 1.1x its EBITDA instead of 11x for the industry average and 6x for AOL (AOL).

It's likely that shrinking the share count would force a revaluation of Yahoo!'s core business, because there would no longer be as many moving parts and excess cash on the balance sheet.

Oh, and we haven't even discussed what will happen to the value of the core when Yahoo! does a huge reduction of head-count that's sorely needed.

A big Yahoo! stock buyback is just a good idea. That is, if you're a shareholder looking for a strong increase in the value of the stock, rather than a venture capitalist trying to unload a company.

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